Leasing Logistics

If farmland leases set on automatic pilot ever made sense in calmer economic times, they no longer do…not with spikes in commodity prices, higher input costs and farmland values now in play.

Landlord and tenant should revisit their lease arrangements every year to ensure they share revenues equitably, in proportion to their respective contributions to the enterprise. Either party's share or contribution can be quickly skewed by today's volatile changes in costs and commodity prices, says Bruce Johnson, ag economist at the University of Nebraska-Lincoln.

“Keep it (lease) current. Adjust it yearly,” he advises. Don't lock in long-term lease terms. Otherwise, he adds, “Somebody is going to shoot himself in the foot.”

It's historically not a comfortable conversation, says Farmers National Company Professional Farm Manager Pat Hengen, Honey Creek, IA. But it's a conversation that needs to take place regularly, he adds.

Not only are annual negotiations advisable, says Hengen, but pushing up the schedule for negotiations also deserves consideration. It allows an earlier commitment to buying inputs such as seed and fertilizer in order to capture early purchase and volume discounts. That can involve a lot of dollars on the table, he says.

FLEXIBLE LEASE AGREEMENTS can help equitably share revenue between landlord and tenant. Provisions in those leases can account for quick shifts in contributions to the enterprise by either party, owing to sharp increases in farmland values and rental rates, and dramatic jumps in seed, fuel and fertilizer costs.

Cash rental rates increased by an average of 21% between 2007 and 2008 in the Seventh Federal Reserve District, which includes Illinois, Indiana, Iowa, Michigan and Wisconsin. Land values in the district rose by an average of 14% from April 2007 to April 2008, according to the Federal Reserve Bank of Chicago May newsletter.

Cash rental rate increases for Nebraska cropland categories (dryland and irrigated) ranged from 17% to 24% between 2007 and 2008, says Johnson. “It's the biggest increase in one year that we've ever seen (for the state).” Farmland values for all classes of cropland in the state climbed around 25%, according to Nebraska surveys overseen by Johnson at the University of Nebraska.

Johnson doubts that these levels are a farm real estate bubble. He views them as a fundamental shift. Although production costs are rising steeply, commodity price-driven revenues from land have risen even faster.

Combine that with rapidly changing farming practices in genetics, tillage and purchases of chemicals, fertilizer and services, and you have a recipe for quickly outdated leasing terms, Johnson says.

Record advances in commodity prices in the past year are, of course, the major part in the equation for equitable revenue sharing between landowner and tenant. “As gross (farm) income increases, more and more landowners want a piece of the pie,” says Hengen at Farmers National.

Both traditional crop-share and cash leases can be drawn up with flex provisions that account for shifts in costs and revenues to protect both landlord and tenant. Though they have their drawbacks, flex leases are worth considering in addressing today's volatile cost/revenue streams.

INTERACTIVE LEASE CALCULATORS that can help guide you to equitable lease arrangements, including flex leases, are available online from several universities. The University of Nebraska-Lincoln Ag Economics Department calculator can be found by going to www.agecon.unl.edu. Click on “Nebraska Farm Real Estate,” and then “Farm Lease Calculator.” The calculator is an interactive online Excel spreadsheet. Landowner and tenant can plug in their respective costs and projected yields and crop prices to see profit sensitivity to cost and revenue changes for landlord and tenant.

Flex leases are not new. They have been around for some time as a way of tailoring such traditional leasing arrangements as crop-share and cash-rent leases to specific or unique landlord/tenant circumstances. And, they now are drawing more attention as a way to address the rapidly shifting landscape of input costs and commodity prices.

“It's the same game it's ever been, but with bigger numbers,” Hengen says. And those bigger numbers make tailoring leases to deliver equitable revenue sharing between landlord and tenant that much more critical, he adds.

Flex leases may be tied to yield, commodity price or a combination of the two.

A flex lease, for example, may include a base cash rent level in dollars/acre, which is adjusted up or down according to how much crop revenue falls above or below some agreed-upon level in the lease.

The accompanying flex lease agreement for corn and soybeans is one example, which Matt Lorimor, Thurman, IA, has with a couple of landowners. In this one, the landlord shares in potential upside reward in return for accepting a lower fixed cash rent than might be commanded under a straight cash lease, according to Lorimor.

In return for accepting the lower cash rental rate (a base rate) of $140/acre, the landowner receives an additional payment equal to 45% of the net profit per acre. Of course, if the crop doesn't yield well or markets soften dramatically, the landowner might not enjoy any payment over the $140.

And for Lorimor? With the $140/acre base cash rent being significantly less than what he'd pay for the same land under a straight cash lease, he has less cash at risk. That's what he gets in exchange for sharing a portion of net income potential.

How yield and price (revenue and profit) are determined under such a flex lease can be agreed upon by landlord and tenant.

Yield might, for example, be determined by weigh tickets, yield monitor or storage bin capacity, says Johnson. Price determination might be local cash price at the co-op/processor on a specified date, an average over a specified time period or futures contract price minus normal basis value for the location of the farm.

IN LORIMOR'S CASE, he and the landlord agreed to peg the price to the average of Wednesday prices during the first five weeks of the year and the 11th through 15th weeks of the year at a Council Bluffs, IA, grain company.

Today's greater potential upside rewards are making some landlords more willing to accept downside risks in return for a chance to benefit from upside potential, according to Hengen and Johnson. “The value of risk is greater than ever before,” Hengen says.

Flex leases can be flexed in any number of ways, Hengen and Johnson say. The flex may be base cash rent that's adjusted up or down. Or, the lease may be written where the base cash rent is the floor that adjusts only upward but not downward, as in the flex agreement Lorimor has with his landlord. The adjustment can be based on some percentage of net income or some percentage of gross income above a certain level.

Similar adjustments tied to yield or commodity price fluctuations can be written into crop-share agreements, which may divide the crop between tenant and landlord along such traditional splits as 50-50, 40-60 and one third-two thirds. “Some of these old traditional shares (in crop-share leases) worked 40-50 years ago, but they are not appropriate today, given the changing farming practices and escalating values of real estate,” Johnson says.

Johnson cautions that it's wise to put a bottom and a cap on how low or high rent can go, considering the volatility in crop prices and input costs. For example, what if corn were to go from $5/bu. to $7/bu. under a flex lease? Cash rent tied to commodity price could rise drastically to a tenant's disadvantage. Lack of an opportunity to hedge against that much of a price change could leave a tenant exposed to unrealistically high cash rent.

SOME LEASE TERMS, under farm program provisions, require (or permit) the landowner to participate in farm program payments. The terms may affect how the Farm Service Agency (FSA) determines the division of farm program payments between landlord and tenant. Where there's a question, checking with your local FSA office is advised, Johnson says.

The trend is toward more cash rental agreements with flexing provisions for yield and/or price, according to Hengen. One reason some landlords favor cash leases is that they don't have to be involved in marketing.

For hands-on landowners, a custom operation lease may be more to their liking. The landowner pays for input costs and pays the operator to grow and harvest the crop while receiving 100% of the crop. In this case the landowner controls the marketing, is responsible for drying/storage, accepts all of the revenue risks and receives 100% of government program payments.

Many different kinds of farmland lease arrangements are being written, with numerous modifications that address special circumstances, such as: large fields or small fields, kinds of services and equipment that a tenant brings to the table, whether the land is in a hail-prone area, environmental goals important to the landlord and additional uses of land such as fee hunting.

“Both parties have to be willing to do some number crunching — doing their homework,” Johnson says. A generic flex lease needs to be tailored, he says.